What is the Resource Super Profits Tax?
Conceptually at least, the proposed Resource Super Profits Tax (RSPT) is designed to be a tax on economic rents (economic rent is another word for abnormal or super profits). Economic rent from resource exploration, development and extraction can be defined as the excess of revenue over costs where costs are defined to include a 'normal' rate of return on capital. So in theory, it is a tax that is designed to apply to profits over and above those which are deemed to be 'normal'. Under standard competitive conditions, the presence of excess profitability would attract new entrants and encourage investment in increased productive capacity by established firms. This would increase supply and place downward pressure on commodity prices until economic rents (excess profits) were eliminated. However, economic rent in a mineral resource industry, may persist in the long run owing to the quality or scarcity value of different ore deposits or fossil fuel fields.
Why use it ?
The key objective in resource taxation is to enable the government to obtain some payment in return for the extraction of the community's resources. Ideally, a resource tax system should be designed to ensure that the government receives through this mechanism no more than the value of the economic rent while minimising distortions to private decisions.
Is the imposition of such a tax fair ?
This is clearly a subjective question. By way of background, property rights in the mining sector are granted often by way of leases over land (although some miners may own the land outright). Regardless of ownership, miners need to apply to the Government for a licence to extract resources from the land in return for agreeing, among other things, to pay legislated royalties and taxes.
Lease, exploration and licensing permit fees tend to be minimal in the scheme of things. As an example, In Australia, seven exploration permits in highly prospective areas were assigned on the basis of a cash bonus bid between 1985 and 1992. In 1999 prices, the value of the winning cash bid ranged from $1 million (1992) to $20 million (1985), with an average of $9 million. So the Government (on behalf of all Australians – this is important as this is not supposed to be a political argument) has always looked to royalties (which are based on production not profits) and taxes to ensure that it is adequately compensated for the extraction of non renewable resources.
The problem being that royalty percentages were agreed upon at a time when commodity prices were much lower. Miners like BHP and RIO have enjoyed super normal profits for the best part of a decade as demand from China, India and the rest of the developed world has put upward pressure on commodity prices. Profits have not been eroded, as is normally the case in a competitive market, because of the high barriers to entry imposed. Companies that have rights to mine on lucrative sites do not give these up cheaply in a commodity boom. So we are left in a position where the Government can either do nothing, and let a fortunate few benefit from the commodity boom, or they can act to redistribute the wealth more evenly across all Australians. After all, these minerals are in effect beneficially owned by all Australians. Regardless of which government is in power, the latter option makes sound economic sense. The delicate balancing act of imposing a sensible tax without significantly impacting upon employment and investment is clearly the more difficult, and debatable, aspect.
How is the tax calculated?
In basic terms, a tax of 40% is to be charged on the profit (after costs) derived by a project over an above the return that would 'normally' be expected. In practice, the calculation process is rather complex and beyond the scope of this report.
Nevertheless, a simplistic, but largely theoretical, example follows:
|
Example XYZ Company borrows $1,000 at 8%p.a. to invest into a mining project with a 1 year horizon. Revenue made over the project was $3,500. Operating costs totalled $500. Financing costs totalled $80. Revenue $3,500 In addition, XYZ must also pay the company tax (after deducting
financing costs and RSPT tax paid) as follows: In this example actual cash profit before tax was $1,920. Tax paid totalled $1,096, which works out at an effective tax rate of 57%. (As an aside, BHP has publicly stated that its effective tax rate would increase from 43% to around 57% if the RSPT is implemented). |
What is going to be the impact on our preferred resources exposures, including BHP and RIO ?
Analyst estimates of the likely impact on key resource stocks differ widely depending upon the assumptions used. Expected reductions in the Net Present Value (NPV) for BHP and RIO are roughly as follows:
|
Company |
Reduction in NPV |
|
BHP Billiton (BHP) |
between 5% and 20%. |
|
Rio Tinto (RIO) |
between 9% and 20% |
It is important to note that the NPV of a resource company will, and usually does, differ from its share price. Prior to the announcement of the RSPT, analyst estimates of the NPV for BHP ranged from around $45 to $55. For Rio they ranged from about $75 to $95.
Using the midpoints we note the following:
|
NPV (Before RSPT announcement) |
NPV if RSPT is introduced |
|
|
BHP Billiton |
$50 |
$43.75 |
|
Rio Tinto |
$85 |
$72.68 |
As the share prices of both BHP and RIO are currently lower than their implicit value, we recommend clients continue to hold these stocks. As more details of the operation of the RSPT are released, more accurate valuations are likely to become available. It should be noted that further taxation in the sector, including a carbon tax in some shape or form in coming years, cannot be ruled out.
What might happen from here ?
The Government has set out a timetable for preliminary discussion. The main point of conjecture at this stage relates to what is known as the "RSPT allowance rate". The allowance rate (which, conceptually, is similar to the 'normal profit' rate of return) has been proposed to be set annually at the 10 year government bond rate. In our view that logic appears flawed because the 10 year government bond rate is the rate of return possible from investing in what is almost a 'risk free' asset. A mining project of course is much riskier and so it makes sense that a higher rate be used. Indeed the RSPT has been modelled off the existing Petroleum Resource Rent Tax (PRRT). The PRRT applies a hurdle rate to increase the deduction available before the PRRT is levied in a similar way to how the RSPT is proposed to operate. Exploration expense deductions are increased by the 10 year government bond rate plus 15%. Operating expenses are increased by the same bond rate plus 5%. So, while the PRRT has, in our view, correctly taken into account the riskiness of the project, the RSPT has not. This provides reasonable grounds for the mining lobby to argue that the RSPT, in its current form, needs amendment.
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